Developing Stand Density Management Regimes Participant’s Workbook 4 • 1

Lesson 4: Economic Principles of Timber Production

An Overview

45 minutes

Lesson Objectives▲ To promote a common understanding of economic principles that are pertinent

to silviculture investments

▲ To make participant’s aware of the difference between stand level analyses and forestor estate level analyses.

Method: Introduce the Guidelines – Lecturette▲ Go over the main sections outlined in the guidelines

▲ Provide a summary of Appendix 1 – Predicting Timber Values

4 • 1

Economic Principles

Spacing – When is it a good investment?

Key elements

▲ Objectives – Forest estate level objectives

▲ Time – Using discount rates and economic analyses

▲ Revenue/Value – Assumptions and information

▲ Costs – What to use

▲ Site Conditions – Growth potential –

How to factor it into the analysis.

Participant’s Workbook 4 • 2 Information Session

ObjectivesForest Estate or Stand – Which should I use?

The guidelines provide a production economics background for evaluatingstand density management options.

• Production economics is the process of determining which, among all treatment options capable ofmeeting forest management objectives, will maximize the return on treatment investment forthe forest estate owner.

• This approach is consistent with the philosophy that the purpose of stand density management isto achieve the timber and non-timber production objectives of a forest management plan.

These stand level economics principles are not intended to address social welfare objectives such asincome distribution or employment creation.

Therefore to properly assess the economic value of a treatment regime it must be viewed in the contextof the Forest Estate.

Thus the stand level economic analyses described in the guidelines are only an input to the moreholistic forest estate level of assessment.

• It must also be stressed that the models used for Forest Estate planning are run by assumptions andprovide imperfect views of reality. All results should be treated with caution and be used as an aidto decision making, not as the decision maker itself.

The treatment must fit within the Forest Estate strategy or treatments may go against theobjectives for the area. Thus it is key to identify forest level objectives and weigh stand densitydecisions in that light.

Economic Principles

ObjectivesForest Estate or Stand – Which should I use?

The guidelines provide direction forstand level economic analyses

▲ Forest Estate economic analysis is notcovered by the guidelines.

However...

▲ Ideally, stand level analyses are used withinForest Estate Models to determine appropriatetreatments – this is the intent for your localplanning units.

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Developing Stand Density Management Regimes Participant’s Workbook 4 • 3

Time – How to Account For ItInformation about the timing of standactivities is required, since various costs andbenefits usually occur during different timeperiods over the life of a stand.

• Economic analysis converts all costs andbenefits to value in today’s dollars. Thisconversion process is referred to asdiscounting. The net present value (NPV)is the sum of all discounted benefits ofsilvicultural activity or regime, lessdiscounted costs.

• Final stand net revenues (revenue lessharvest cost) are obtained at the end of theexpected rotation period. The procedurefor calculating the net present value of adensity management treatment in a singlestand is straightforward; the net presentvalue of a juvenile spaced stand iscompared to that of the same standwithout spacing.

In order to make economic comparisons between different stands or different treatments, however, netpresent value must be calculated over the same time period.

• That is, for each present value, the starting point must be the same for each stand or treatment, andthe end point must be the same expected rotation length. Since the timing of different standtreatments and the rotation lengths of different stands are rarely the same, it is often impossible tocompare treatments and stands in this manner.

• In these circumstances, the net present values must be converted to a site value (SV).

The overhead shows a relatively complex equation that can be used to calculate the Site Value for astand. In reality you will not likely hand calculate this value, instead it will be done for you in aneconomic model (for example the TIPSY economist).

A site value is the present value of an infinite number of successive rotations on a site managed underthe same regime. An economic comparison of two or more stand management regimes is madepossible by calculating and comparing the site value of each, even though they may differ in thetiming of stand treatments or expected final harvest.

This type of analysis helps rank the economic attractiveness of treatment options.

This can be achieved by: obtaining more value at harvest through harvesting efficiencies, higher valueproducts, mill efficiencies (fewer larger logs for the same volume) or greater lumber recovery factor.These conditions must add up to more than the cost of treatment carried over the time until harvestusing the discount rate of the day. If the SV is not higher the treatment may still be beneficial at theForest Estate Level, making it an option (described as a provisional option in the “StructuredDecision Process”).

4 • 3

Economic Principles

Stand Level AssessmentsTime – how is it accounted for?Net Present Value vs Site ValueWhich one where?

Treated vs Untreated Different RegimesNet Present Value – Site Value –

SV =Ri (1 + r) A − i − Ci (1 + r) A − i

i = 0

A

Σi = 0

A

Σ

(1 + r ) A − 1

NPVu

= (Ru

- Cu

- Cd

+ Svu) / (1+ r) A - a

NPVt

= Rc- Cc

- Cd

+ (Rt- C

t+ Sv

u) / (1+ r)A -a

Participant’s Workbook 4 • 4 Information Session

Revenue and ValueAssessing the economics of a proposedsilvicultural activity requires informationabout:

• benefits and costs of the activity from thetime of stand establishment to the time ofexpected harvest

• costs and benefits may be actual, if theyhave occurred, or expected if they areanticipated in the future.

There are no guarantees with economicanalyses, or all of our RRSPs would be twicewhat they are today!

There are some important factors and we willgo over them to promote a common dialogueon revenue assumptions.

Economic Principles

This is where we dust of the crystal ball.Three key factors:

▲ Valuation point

▲ Real price changes

▲ Relationship with piece size and price

Revenue and Value

4 • 5

Economic Principles

Valuation Point

Coast

Interior

Valuation PointTo allow valid comparisons some form of value orworth must be used.

For simplicity, the value of harvested timber can bederived from the selling price of manufacturedend-products. A common practice is to evaluate thetimber as it moves up manufacturing stages to apoint where a market price for a product can bedetermined. At that point any wood qualitydifferences that affect the product are reflected inthe price.

• In the coastal region of British Columbia theend-product values are derived from logtransactions on the Vancouver Log Market(Ministry of Forests, 1995b).

• In the interior, where log markets areuncommon, a market value is derived fromprocessed lumber and residual wood chips(Ministry of Forests, 1995a).

Developing Stand Density Management Regimes Participant’s Workbook 4 • 5

Real Price ChangesA word of caution – lots of factors are involved.

The graph shown (Figure A1-2 from Appendix 1 of the guidelines) shows trends in real lumber pricesin constant 1995 Canadian dollars (western spruce–pine–fir, kiln dried, standard and better, 2×4,random length lumber). It indicates the volatility surrounding price.

Average 1960–1995price

$380/MBF

4 • 6

Economic PrinciplesReal Price Changes

No clear trends emerge in real lumber pricesin constant 1995 Canadian dollars

Supply and Demand are the Drivers

CAUTION IS ADVISED!

$/thousand board feet (MBF)

600

550

500

450

400

350

300

250

200

Average 1960–1995price

$380/MBF

1960 1965 1970 1975 1980 1985 1990 1995Year

Conclusions and recommendationsTime in and of itself has no effect on prices, and past prices do not dictate what future prices will be.Market supply and demand forces, which change over time, are what cause prices to change. Use ofsimple trend models to predict future prices assumes that forces of supply and demand that caused thepast price changes are closely correlated with time and that this correlation will continue into thefuture. This assumption is simplistic, and warrants caution in the use of models based on similar logic.

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Participant’s Workbook 4 • 6 Information Session

Having said that the guidelines recommend:

• Given the factors which mitigate against real price increases, it is appropriate to select aconservative estimate of future real price increases.

• The estimates presented in the table are examples of those typical within the range of mostestimates. They are not unreasonable, especially if limited to the 50 year time period shown.

However, it is recommended to look at other forecasts, your species mix and product potentialmay be unique and vary from this estimate.

Long-run real log price increasesThe table shown is Table A1-1 from Appendix 1 of the guidelines.

The most notable part of the information presented is the lack of long-term price increases from any ofthe species identified.

However, the footnote states:

It should be noted that these data are presented only as an example of forecasts typical ofthe range of values found from a number of recent analyses. They should not beconsidered the only, or the most accurate forecast of timber prices increases available.See also Feltham and Messmer, 1996.

4 • 7

Economic PrinciplesLong Run Price Increases

Coast

Caution is the key – note the relatively flat long-term forecast

It is recommended to look at other forecasts.Your species mix and product potential may be

unique and vary from this estimate.

Forecastperiod Tree species (% price increase/year)(years) Douglas fir Cedar Hemlock True firs

1990–00 1.4 3.8 0.2 0.8

2000–10 0.1 -0.7 -0.6 -0.2

2010–20 0.4 0.5 0.1 0.3

2020–30 0.1 0.3 0.1 0.1

2030–40 0.1 0.3 0.1 0.1

Average 0.4 0.9 0.0 0.2Source: H.A. Simons Strategic Services Division and Cortex Consultants [1993].

Real price increase forecasts for logs from the coastal region

Developing Stand Density Management Regimes Participant’s Workbook 4 • 7

Long-run real lumber and chip pricesThe table shown is Table A1-2 from Appendix 1 of the guidelines.

• The guidelines suggest the real lumber and wood chip prices presented in Table A1-2 mayprovide reasonable long-run estimates (Stone et al., 1996).

• The long-run real price of 2×4 lumber for each species is the average for the periods studied,while the price for other dimensions is a function of the 2×4 price and the average price ratio ofdimension lumber to 2×4 lumber.

4 • 8

Economic PrinciplesLong Run Price Increases

Interior

These values are used in the TIPSY economist and mayprovide reasonable long-run estimates

Lumber ($/MBF) Wood ChipsSpecies 2×4 2×6 2×8 2×10 ($/BDU)

Fdc 455 460 455 560 110

Pl 380 369 376 452 110

Hw 406 406 414 491 110

SS 380 369 376 452 110

Cw 482 482 583 583 15

Sw 380 369 376 452 110

Fdi 426 430 439 554 110

Source: Stone et al., 1996.

Default lumber and wood chip prices used in the TIPSY ECONOMIST(constant 1995 dollars)

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Participant’s Workbook 4 • 8 Information Session

Real Per Annum Price Increases – A Word of CautionGiven the lack of any clear trend in past real lumber prices (as indicated in Figure A1-2 [OH 4.6]), andthe likelihood of only modest real price increases for logs in the future, caution is warranted in makingfuture value assumptions when evaluating the economic efficiency of silvicultural investments.

4 • 9

Economic Principles

Long Run PriceIncreases

2%

1%

3%4%500

450

400

350

300

250

200

150

100

50

00 10 20 30 40 50 60 70 80 90 100

Stand age

Cumulative real price increase

• For example, the overhead illustrates the cumulative effect of annual real price increases of1%, 2%, 3%, and 4%.

• If these annual price increases were compounded over a period of 75 years, as they might be in ananalysis of juvenile spacing for instance, the resulting cumulative increase in timber value wouldbe 111%, 342%, 818% and 1795%, respectively.

The significance of these extremely high future values is considerable in the calculation of net presentvalue or site value of a stand density management investment analysis.

The compounding effect of an assumed annual price increase can be reduced by limiting the periodover which the compounding takes place.

• For example, an assumption of a 1% per annum real price increase over the first 25 years with noreal price increase thereafter results in a cumulative real price increase of only 28%.

• Use of <1% per annum real price increase over 25 years may provide a reasonable prediciton offuture falue.

The figure used is from Appendix 1 (Figure A1-9) of the guidelines.

This is why you want to invest early in your RRSP! (or is it too late?)

Developing Stand Density Management Regimes Participant’s Workbook 4 • 9

Harvesting costsHarvesting costs can be categorized by harvesting phase, such as road and site development costs,tree-to-truck costs (felling and yarding), log haul costs (loading, truck haul, towing, or barging), andadministration and overhead costs. The effects of density management on each cost phase must beaccounted for in any analysis.

Development, overhead and administrative costs are examples of fixed harvesting costs.

• Density management treatments that result in changes to the volume of timber produced by astand will not affect total fixed harvesting costs, but will affect the average fixed costs per cubicmetre of timber produced.

Density management treatments have a larger impact on certain components of tree-to-truck and loghaul costs, which are examples of variable costs.

• For instance, log haul costs are influenced primarily by changes in loading time resulting from thenumber of logs required to complete a load. However, the cost of the loading component of loghaul costs is relatively small.

• Density management practices havegreatest impact on tree-to-truckcosts, particularly theyarding component.

For further information on more detailedaspects of harvesting costs, refer to theMinistry of Forests Appraisal Manuals(Ministry of Forests, 1995 (a and b) aswell as Stone (1996 a and b).

Harvesting costs can be inserted into theTIPSY economist to approximate localconditions. Appendix 2 in the guidelinesprovides a sensitivity analysis to indicatewhere the “break-even” point oftreatment occurs by varying harvestingcosts.

For example, how much of a differencein tree-to-truck costs is required toequate the returns from the thinned andunthinned stands? Or, at what harvestcost does the net economic gain fromthinning equal zero? And, how does itdiffer from the tree-to-truck costs usedfor the unthinned stand?

4 • 10

Economic PrinciplesHarvesting Costs

How does density management affect costsof the various harvesting phases?

Fixed costs No change

Tree to truck Less – fewer stems yardingthe biggest factor

Log haul Less – fewer stems

See Stone 1996 articles and the Appraisal Manual for help.

Participant’s Workbook 4 • 10 Information Session

Future Harvest CostsThe guidelines provide the following example that you may wish to lead the group through.

Consider two coastal hemlock stands at an economic rotation age of 80 years. One is unthinned andthe other is thinned to 900 trees/ha. Thinning costs are $660 at age 17, which discounts to $339 at agezero. This is the amount by which the site value of the thinned regime must exceed that of theunthinned regime to offset the cost of treatment. The average default tree-to-truck costs in TIPSY aresimilar ($ 14.36/m3 Vs $ 14.43/m3) for the two regimes.

• Set the thinning costs to zero as in the preceding example and reduce the tree-to-truck costs of thethinned stand in small increments using the “Constant Cost” option until the difference in sitevalues between the two regimes at age 80 matches the discounted spacing cost of $339.

• Table A2-8 shows that treatment would have to reduce tree-to-truck costs from $14.36 to $9.90/m3

for a savings of $4.46.

• That is, it would be justified economically to thin the stand to 900 trees/ha if it reduced theaverage tree-to-truck costs by 31% relative to the unthinned stand assuming no increase in endproduct value.

4 • 11

Economic PrinciplesFuture Harvest Costs

Tree-to-Truck – Working With the NumbersUse TIPSY economist to ‘game’ harvest costs – anexample is spelled out in Appendix 2 of the guidelines.Example

▲ Discount the cost of spacing to year zero($660 at 17 years = $339 at year zero).

▲ Set thinning costs to zero and reduce tree-to-truckcosts until the site value between the two regimesat the economic rotation (age 80) in the examplematches the discounted spacing cost($339 in this case).

Tree to truck costs need to be $9.90/m3 comparedto $14.36 used by the model.

Is this a reasonable cost?

Developing Stand Density Management Regimes Participant’s Workbook 4 • 11

Milling costsThe guidelines provide the followinginformation:

Coast

• Milling costs need not beaccounted for in economicanalysis based on log values, sincethe log prices used in the analysisshould already reflect differencesin milling costs.

• However, when the analysis isbased on lumber and wood chipend products, the effects of densitymanagement treatments on millingcosts must be accounted for.

• Larger log sizes result in lowermilling costs, although otherfactors, such as log taper, mustalso be considered. Stone (1996a),and Stone et al. (1996) illustrate amethod for predicting changes inmilling costs.

• Lumber Recover Factor appears toplay a significant role inmilling costs.

Stone in An Economic Analysis of Lumber Manufacturing Costs in the Interior of British ColumbiaWP-6-014, 1996c provides the following:

By using formula suggested by Stone (1996c) an estimated cost of milling can be created.

Average Total Cost Function ATC = 2234.31 LRF-0.5199

or

Average Total Cost Function ATC = 422.66 – 2.0521 LRF + 0.003418 LRF2

• What this does is provide a cost of milling that relates to the diameter of the input logs.

• Using a top diameter of 10 cm provides a LRF of approximately 150 board feet per cubic metre.

• A log with a top diameter of 40 cm has a LRF of about 230 board feet per cubic metre.

• These relate to $220/MBF milling cost to about $130/MBF or about 70% increase in milling costsfor the small dimension lumber.

NOTE – The interior stumpage appraisal system derives the value of standing timber by deductingall harvesting, transportation, and manufacturing costs from the value of lumber and chipsfrom the stand. Therefore higher milling costs for small dimension wood result in reducedstumpage payments for the stand.

Economic Principles

4 • 12

Milling Costs

Used for Interior RunsFor more information see Stone (1996a) andStone et al. 1996.Points to ponder

▲ Lumber recovery is greater with larger logs

▲ Logs with a 10 cm top cost 70% moreto mill than logs with 40 cm tops

▲ Stumpage deducts the difference

Participant’s Workbook 4 • 12 Information Session

4 • 13

Economic PrinciplesSilviculture Treatment Costs

TreatmentsCost will affect your economic analysis

▲ Cheaper treatments will look more attractive

▲ Local market will dictate – use local numberswhen available

▲ Later treatments are more attractive than early ones

▲ Treat when biologically optimal

Silviculture Treatment CostsThe guidelines provide the following information:

The cost of stand density treatments is usually a function of site and stand conditions such as:

• road access and travel distance,

• the average slope of the site,

• original stand density,

• the number of trees removed, and

• the average height and diameter of the trees removed.

• Local labour market conditions may also influence treatment prices.

– For instance, the number of silviculture operators available to bid on a project and the amountof work currently under contract may have a substantial effect on treatment prices.

– Local market treatment costs should be used to assess density management options.If this information is unavailable, regional average costs may be used.

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Developing Stand Density Management Regimes Participant’s Workbook 4 • 13

Selecting a Discount RateThe guidelines provide the following information:

Silvicultural investments are characterized by treatment costs and benefits which occur in differenttime periods through the rotation. These costs and benefits must be converted to present values inorder to assess investment efficiency.

• The purpose of a discount rate in an economic analysis is to reflect the preference that societies,organizations, or individuals have for present, versus future consumption.

• Income received, or costs incurred today are considered to be worth more than income orcosts which occur in some future time period.

• The rate of discount is used to determine how much less future revenues or expenditures representin today’s dollars. Discounting permits a comparison of various flows of benefits and costsoccurring over time in a consistent and logical manner.

Choice of a discount rate is influenced by markets for capital, opportunity costs of capital, risk, andperceptions of risk, uncertainty, inflation expectations, differences in the rate of borrowing andlending, as well as other factors.

• Governments and private sectors are both influenced by these factors, however private sectors ofthe economy are affected to a greater degree due to uncertainties in future product demand,natural resource conservation policies, and the wider range of alternative investmentopportunities available.

Heaps and Pratt (1989), in The Social DiscountRate for Silvicultural Investments, estimated thediscount rate using the social opportunity cost ofcapital for public sector investments in Canada,and found a range of between 3 and 7%,depending on how risk and uncertainty areaccounted for. They argued that a risk-free rateshould be used for silviculture investments,and recommended a discount rate of between3 and 5%.

The Ministry of Forests uses a 4% real rate ofdiscount for public sector forestry investmentanalysis. The discount rate, whether public orprivate, is a “ real” discount rate. This meansthat it does not include any inflationaryexpectations. Inflation is “ netted out” of a realdiscount rate since it is assumed to affect bothcosts and prices equally over time.

Whatever discount rate is selected, it must be usedconsistently for all silvicultural treatments. Forexample, although a lower discount rate would“improve” the economics of juvenile spacing, itwould also reduce the benefits derived fromcommercial thinning. The discount rate is clearlya two-edged sword.

4 • 14

Economic PrinciplesSelecting a Discount Rate

What about 4%?Government used real rate

– inflation factored out.

2%

1%

3%4%500

450

400

350

300

250

200

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50

00 10 20 30 40 50 60 70 80 90 100

Time

Value (%)

Participant’s Workbook 4 • 14 Information Session

4 • 15

Economic PrinciplesSensitivity Analysis

This can be used to “game” futurevalues and costs as well as assessing

“how robust” the analysis is.

An Important Step

The importance of sensitivity analysisSensitivity analysis is an important analytical method used to evaluate the effects of risk anduncertainty in economic analyses.

• Sensitivity analysis involves re-calculating the site value of a silvicultural treatment using a rangeof values around key factor assumptions.

• Key factors in an economic analysis include, future revenue, harvest cost, milling costs,silviculture costs (regeneration, tending, protection, administration) and investment period(rotation length).

For example, a sensitivity analysis of future harvesting cost would involve repeating the economicanalysis using harvesting costs that are slightly higher and slightly lower than the expected value.

• The usual approach is to test values within plus and minus an arbitrary percentage (e.g., 10%) ofthe expected value.

• The sensitivity analysis is performed while keeping all other key factors constant.

The three site values from the sensitivity analysis (base case, -10% and +10%) are then compared;large differences indicate that site value is “sensitive” to small changes in harvesting cost.

Sensitivity in one or more key factors suggests that the economic analysis is not robust, and may leadto errors of interpretation. The outcome of the sensitivity analysis will determine whether all inputvalues and assumptions should be re-evaluated.

Developing Stand Density Management Regimes Participant’s Workbook 4 • 15

An example from Appendix 2

The example analyses were based on the assumption that real end-product prices remain constant overtime (i.e., wood products will not change relative to the cost of production). Under this assumption,juvenile spacing show no net gain in value over no treatment. This leads to the question,

• “How much of an increase in end-product price is required to cover spacing costs?”

• Assume the landowner expects that real end-product prices will rise steadily for the next 25 yearsand remain constant thereafter.

• What rate of increase is necessary to make the thinned stand as financially attractive as theuntreated stand assuming all other costs and values remain constant?

To calculate this “break-even” price increase, discount the cost of thinning ($598) from age 16 tozero at 4%. This amounts to $319, which is the net gain in site value at age zero needed to covertreatment costs.

Set the cost of thinning to zero, and then elevate the “Real Price Increase” in small steps for bothstands until the site value of the thinned stand exceeds that of the untreated stand by $319 at age 60.An increase of just over 2.6% is needed to cover spacing costs. Note that a 90% total increase in priceresults from the 2.6% price increase over 25 years. This type of analysis can be used as a“ reality check.”

Remember – site growth potential has a major influence on economic analyses as tree growth isgeometric as is compounding interest. Good sites can keep up with discounted costs.

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